Sunday, March 04, 2007

Congratulations for Not Forecasting Recessions

Mark Thoma at Economist’s View cites an article by Daniel Gross about the inability of economic forecasters to forecast recessions. A maintained assumption of everyone who discusses this seems to be that this failure of economic forecasting reflects badly on economists if reflects on them at all. I would suggest, however, that the inability to forecast recessions in practice is, when properly understood, actually a point in economists’ favor.

Suppose that we can represent the consensus forecast in one number that indicates the consensus probability of recession. A consensus recession forecast would then refer to a situation is which this number exceeds 50%. But we know that the consensus usually changes slowly, so a 51% recession forecast is likely to have been preceded, with some lag, by a 40% forecast, and that by a 35% forecast. But what happens when the consensus calls for a 35% or 40% chance of recession? What happens is that policymakers – usually at the Fed – start aggressively trying to prevent a recession. (That is if they didn’t already start when the consensus was at 30% or lower.) If they do a good job, the consensus never gets to 50%. So if the Fed is doing a good job, it’s unlikely that one will ever see a consensus recession forecast, successful or otherwise.

And the Fed’s ability to do a good job of preventing recessions depends in part on its economists – as well as on those various economists over the years that have studied the implementation of monetary policy and helped the Fed learn how to use it effectively. If it were the case that forecasters could successfully forecast recessions, it would indicate that these economists had failed in their task.

15 Comments:

Ideally, the forecast should take into account the Fed too. Endogenize it.

If you think that the Fed will prevent a recession in the near future, then your probability should be low. If you think that the Fed won't be able or capable of preventing it... start the doom speak.

On the other hand, those of us in the R.E./D.S.G.E. scene, or trying to get on that scene ;-), seem to have a quite different notion of forecasting and related, than let's say, the large scale econometrics of the '70s.

So, endogenize the Fed. Then if forecasters don't forecast recessions, it's because they have confidence in the Fed's ability to prevent them, which still speaks well for the economists who have helped the Fed prevent recessions.

No doubt they could have done better, but I still maintain that forecastable recessions would be even worse. In the actual world, there is no example of a recession that the Fed knew about in advance and failed to prevent. I think it will be hard to find specific evidence of "misplaced confidence". (In practice, when recessions occur that aren't forecast, it isn't becuase forecasters detected the preconditions but expected the Fed to handle them, it's becuase the forecasters were taken by surprise, just like the Fed.)